Diamonds ’97

June 1, 1997byRussell Shor

Because diamonds and diamond jewelry account for nearly 40% of jewelry store sales, understanding the market can be critical to your success. In this four-part report, JCK examines increasing competition for better-quality diamonds, the advantages of stressing cut in selling diamonds, the success of De Beers’ new diamond solitaire necklace program – complete with a pictorial of new styles – and the growth of cubic zirconia as a legitimate jewelry store category.

ASIA’S QUALITY QUEST MAY FORCE PRICES UPWARD

Asians want better-quality diamonds. Americans want better-quality diamonds. But De Beers says there are only so many to go around. What will give? Prices, of course

More than a decade ago, De Beers marked Asian consumers as a huge group of untapped diamond customers. Building on its success in Japan, De Beers slowly launched ad campaigns to focus Asians’ predilection for precious things on diamonds.

The result: more than 40% of all diamond jewelry sold worldwide today is in Asian markets, up from about 25% in 1985. And now U.S. diamond buyers face more competition for better-quality diamonds.

Asia’s rapidly changing economic status helps De Beers in its quest. The region has the world’s fastest economic growth rates and a growing liberalization of some of the world’s most dogmatically controlled economies. And while the region’s heady economic growth slowed last year, it will certainly pick up again, even if it’s at a slower pace.

Asian consumers traditionally want quality and value; this is even more pronounced with diamonds. The Japanese, for example, are turning away from off-makes, brownish colors and piques after several years of chasing cheaper diamonds. Even casual jewelry buyers want quality diamonds now.

ASIA’S LEADING MARKETS
1995 diamond jewelry sales in U.S. dollars

Japan

$16,900,000,000

Korea

$1,038,000,000

Taiwan

$495,000,000

Thailand

$499,000,000

China

$270,000,00

Elsewhere in Asia, the story is much the same. Consumers are willing to spend much more of their incomes on diamonds than Americans are, and they’re picky about what they buy.

The inevitable result of these moves toward better stones will be a further polarization of the world diamond market. Better goods of all sizes will become more scarce and cost more, while lower-quality diamonds will continue to decline in value. U.S. retailers should get ready for more price hikes from De Beers Central Selling Organisation as Asian and American buyers compete for an ever-narrowing range of high-quality goods.

The following is a report from Asia’s four largest diamond jewelry markets: Japan, South Korea, Hong Kong and China.

JAPAN: UP FROM ‘DESTRUCTION’

When executives of Maki Jewellery, Japan’s largest retail jewelry chain, saw their bottom line shrink and debts rise, they transformed their company’s emphasis from low, low price to high, high value. Relentless discount advertising helped to create the term “price destruction” – the buzzword in Japan’s jewelry trade until recently.

The company’s 830 stores rang up $1 billion in sales of low-priced jewelry last year. But that was 30% lower than just a few years ago, when Japanese working women and gift buyers went way down-market when Japan’s economy went sour. At Maki they could buy diamonds and still have a good chunk of their paychecks left.

Maki and its competitors grew rich taking Japan down-market during the economic slide of the early 1990s. Now Japan’s $17 billion diamond jewelry market has come full circle. Quality diamonds are becoming the rage again. The circle began to close when an earthquake devastated the Kobe area of Japan in January 1995. “People were able to save nothing but their jewelry,” says Kazuo Kimura, president of Miki Corp. of Tokyo, Maki’s parent company. “This made the country more aware that jewelry is an asset of lasting value.”

While the Kobe disaster shook the national consciousness in many ways, its biggest effect was to help rekindle the Japanese interest in better-quality jewelry – particularly diamonds. Maki and one of its arch competitors in the discount market, Koko Yamaoka, saw sales and profits from lower-quality gold and diamond jewelry plummet while debts rose, as price competition grew ever more cutthroat.

Wholesale-to-the-public operations that once thrived in Tokyo’s Okachimachi jewelry district suffered as consumers sought better quality. The turn to quality began in earnest last year, says Shimao Ishihara, director of the De Beers’ Diamond Promotion Service in Tokyo. The total value of diamond imports to Japan fell 13% but per-carat value rose 14%, says Ishihara, signaling better quality diamonds. “The price-oriented stores have shown little or no growth, while quality-oriented retailers have done quite well despite lingering recession,” he says. “People do have money. But they’re unwilling to spend it without getting something of value in return.”

The move up-market suits the jewelry trade just fine because there is more profit in quality pieces. Paper-

thin margins for cheaper jewelry combined with static sales are a bad combination, says Shinchiro Shimada, managing director of Bambi Jewelry of Tokyo, one of Japan’s largest jewelry manufacturers. “Thin margins require a huge volume of sales to sustain a business,” he says. “People could work on very thin margins as long as they had strong growth, but that’s not possible when the growth disappears.”

This is a major reason for the well-publicized failure of Koko Yamaoka early this year, say dealers who followed the company’s long slide downward. Koko Yamaoka, which had about 130 stores, was one of Maki’s chief competitors until it declared bankruptcy with $550 million in debts in January.

Advertising

Now that De Beers is engaged in a market-share war in the smaller, lower-quality diamond field, its advertising campaigns will continue to urge Asian consumers to trade up.

De Beers is spending almost $40 million in its current Japanese advertising program, a big part of which will go to the Simple Diamond and Carat Diamond campaigns to promote diamond solitaire jewelry. For the most part, these ads stress carat-plus diamonds costing $8,000 or more. This mirrors the American Solitaire campaign, except it will engage supermodels such as Kate Moss to endorse solitaires to Japanese consumers.

Charles Stanley, De Beers market controller, says the campaign appears to be working. He attributes a 16% increase in non-ring diamond jewelry sales last year directly to the Simple Diamond campaign.

Japan’s renewed rush to quality won’t be felt in the world diamond markets just yet. The economy remains sluggish and retailers have a large well of old inventory to draw from. Japanese wholesalers imported record quantities of diamonds in 1995 when the yen soared to its highest post-war rate (90 yen to $1). They made enough to live on through much of this year, barring a sudden market revival. Last year, however, the yen fell 30% and shows no sign of recovery.

Hidetaka Kato, president of Kashikey Co. of Tokyo, one of Japan’s most-respected diamond dealers, says Japanese buyers cannot compete with Americans right now because of the exchange rate. “Americans are getting all of the goods we want, such as 4 grainers to 8 grainers in H VS and SI ranges,” says Kato. “They’re paying 10% to 15% more than Japanese buyers because the exchange rate is in their favor.”

SOUTH KOREA: MOVING ABOVE BOARD

In 1996, the South Korean government recorded about $33 million worth of polished diamond imports. The same year, the trade estimated about $970 million worth of diamond jewelry was sold in South Korea’s growing number of jewelry stores.

At first glance, it looks like South Korean retailers get a great markup. But they’ll be the first to tell you they’re in the same competitive jungle as everyone else. The reason for the big difference in numbers: more than 90% of the diamonds sold in South Korea are smuggled into the country to avoid the heavy duties and luxury taxes levied on diamonds and gold. (Polished gemstones have a 5% import duty; all jewelry has a 10% value added tax and any jewelry costing more than 1 million won (US$1,150) is subject to a 20% luxury tax on the value over that amount. What’s more, the country levies a 30% tax on the amount paid in luxury tax for use in education.

Despite this tax structure, South Korean consumers are so keen for diamonds that most of the country’s 20,000 or so retailers risk steep fines and confiscation of inventories to maintain the supply. The government has promised to reform the tax structure within three years, and the industry trade organizations are lobbying hard to be certain jewelry is part of those reforms, says Yeol Kwang Cha, executive director of the Korean Jewellers Association. However, the nation’s economy has slowed considerably this year, and several high-level scandals involving government and industry leaders have put many reforms on hold. “We hope that’s only temporary,” says Cha.

Unlike most fledgling markets, South Koreans are starting at the top. About 85% of South Korea’s diamond jewelry sales are wedding-related, keeping the price of total diamond jewelry sales at a fairly high average of $1,400, more than double what it is in the U.S. Few consumers are interested in qualities below H SI1 – and SIs only because better goods are too scarce. Like their Japanese counterparts, South Korean consumers want lab grading reports for almost every diamond they buy.

The belief in quality is deeply rooted in modern South Korean history. The country was invaded by Japan in 1910 and survived the Korean War and resulting 40-year standoff with North Korea. Kun Kap Lee, who heads Hwadong Co. of Seoul, a large diamond jewelry manufacturing company with a retailing arm, says South Koreans discovered many years ago that lower qualities are difficult to sell when the need arises, so even the middle class opts for expensive stones.

“A decade ago, $1,000 was several months salary. Now it’s one month for a middle-class worker,” he says. “People can afford diamonds now.”

A decade ago, South Korea was strictly a cubic zirconia market. The government prohibited imports of foreign luxuries such as diamonds and gold, so CZ was the legal jewel of choice. Though jewelers kept trays of the real thing under the counter, business was necessarily limited by the specter of arrest and confiscation. A democratic reform movement swept into the country in 1988, opening the borders to foreign imports. However, an import duty of 40% on loose diamonds and an aggressive government enforcement policy kept things pretty tightly underground until three years ago, when the import duty was reduced to 5%. At the same time, South Korea’s supreme court issued a ruling shifting the burden of proof to the country’s tax authorities before they could confiscate jewelers’ inventories. Because there’s little paperwork involved in most of these transactions, only then did South Korea’s jewelry industry begin to operate openly.

Moving above ground

The industry’s “criminal” past has created a culture of clandestine activity that is starting to create problems as the industry moves above ground. And it may cause many smaller retailers and wholesalers to fall out even in a bull market.

“Virtually all of the distribution channels were set up here during the 40 years that the diamond and jewelry business was illegal,” says Chun Keun Kang, manager of Orient Watch, which is bringing out diamond jewelry lines in a big way. “No one kept books, so they still don’t understand proper accounting procedures. When they try to operate legally, they must make some serious mental adjustments, such as paying normal taxes they don’t factor into their costs now.”

The underground legacy also leaves a whole network of middlemen (called Narkama) who connect independent retailers to the “tax-free” wholesalers and gem dealers who sell smuggled goods. Right now these people and the stores they serve can flourish because they can get around the costly taxes. But when trade becomes more liberal, the large manufacturer/retailers who control much of the higher end market in Seoul will gain the upper hand because they import direct and don’t have the layers of distribution and related costs.

Another potential difficulty is South Korea’s insulated gemological lab structure. The two top labs – which control 50% of the business – are reportedly the toughest graders in the world. Other labs are closely tied to retailers or manufacturers and issue favorable grades for their own goods. The price difference in diamonds bearing the same grades can be 30% or more.

The top labs – Mijo and Woo Shin – say they grade much more strictly than the Gemological Institute of America. However, gemologists and labs in South Korea use a fundamentally different system. “When we first started importing diamonds here in the early 1980s, G VS was thought to be the top, so the labs used that as their best grade. Some of them still do,” says one dealer. “In fact, a Lazare Kaplan D flawless would come out two grades lower in these labs.”

Sun Chi Kim, president of Hanmi Gemological Institute, freely admits South Korean labs use a different standard from GIA and other gem labs. “Our different system helps us to insulate our market against competition from GIA,” he says. “Because we grade differently and are regarded as stricter, our certificates are worth more on the local market.”

Kim believes the GIA system eventually will prevail in the smaller goods market, but not in the carat-plus sector. “Korean labs will certainly try to control the Korean market.”

De Beers promotions

De Beers began to promote non-wedding diamond jewelry two years ago for the first time. As a result, the trade expects increased demand for such pieces. De Beers also helped to move the market by breaking old advertising taboos. It aired the first diamond ads on TV two years ago, which induced several jewelers to follow suit.

Still, there’s a great deal of unease. “We used to advertise top-market pieces, but we realized it invited government scrutiny,” says Byung Gun Park, president of Grangna Co., a midsized retailing operation headquartered in Seoul. He says he imports all of his pieces through legitimate channels. “Right now we’ve found the middle market best for us because the more expensive pieces carry the highest taxes and are most likely to be smuggled. We could never compete in price with those people.”

Despite these problems, the South Korean trade is bullish about the future and sees several trends emerging once the tax barriers are lowered:

Up-market branded jewelry from Tiffany, Cartier and other top jewelry houses will become much more popular. Park predicts a 20% to 30% increase in sales in this market each year once taxes are lowered. “There’s already a market for very sophisticated pieces here from Van Cleef, Cartier, Damiani, Carerra,” he says. “But many, many more people are waiting to buy these pieces because consumers want prestige and brand names.”

Diamond cut will become much more important. South Korea’s top labs don’t issue cut grades and few consumers are yet aware of its importance. However, top retailers and dealers see promoting cut as a niche to get them out of the competitive jungle. Indeed, many believe the Japanese obsession with “excellent-excellent” cut for engagement ring diamonds will come eventually to South Korea. Lee at Hwadong is so certain this will happen that he’s taken on Lazare Kaplan Ideal Cuts in anticipation. They’re a slow sell because he imports them through official channels, passing the high taxes on to consumers. “They have good potential however, because people here are very brand-conscious and quality-oriented,” he says.

Designer jewelry will become more important as the market moves beyond wedding jewelry. Park believes the younger, more affluent generation will look beyond the “commodity” value of jewelry and be willing to pay premium prices for distinctive designs. “There’s a growing class of more style-conscious people who want distinctively designed jewelry and are willing to pay extra for it,” he says. “This is true even in provincial cities. Liberalization will bring these people out of the shadows. But this market will move more slowly than others.”

Meanwhile, none of the dealers and retailers surveyed believe South Korean consumers will move down-market to lower-quality diamonds anytime soon. “We were taught that diamond’s beauty lies in its pure whiteness. I don’t see that changing any time soon,” says Lee.

CHINA: CENTRAL GRADING COMES TO THE CENTRAL KINGDOM

With great publicity, China introduced a National Gemstone Standards code earlier this year. The code is designed to reduce the fraud and deception that have plagued the rapidly growing diamond trade. Fracture-filled diamonds and even cubic zirconia have been passed off regularly to consumers who fully believe they’ve purchased natural diamonds.

Such chicanery was inevitable. China had almost no domestic market for diamonds at the beginning of the decade, but soon may join the U.S. and Japan as a leader in diamond sales. Last year, Chinese consumers bought an estimated $270 million worth of diamonds at retail.

“In China there was no jewelry business for more than 20 years, so no one had any knowledge about it,” says Zhuang Shu Feng, general manager of the Shanghai branch of the China National Diamond and Gem Import and Export Corp., which has diamond and jewelry manufacturing factories and a chain of retail stores.

The government also has established gem labs that eventually will grade every diamond sold in jewelers’ shops. Carat and larger stones may be graded for cut, say dealers.

Foreign dealers complain the labs are too strict. But the new Gem Standards require the labs to make good on diamonds they overgrade, so they err on the side of inclusion, says one major dealer.

The new Gem Standards and the grading labs are rapidly educating Chinese consumers about diamond quality and lasting value. Already it’s beginning to show up in diamond demand trends, says Nelson Wu, who heads the Shanghai office of De Beers’ Diamond Promotion Service. “Right now most demand is centered in I through K colors and SI clarity,” he says. “In Shanghai, however, where people are more sophisticated and prosperous, the standard is now VS and VVS clarity.”

Because Chinese consumer buying power remains lower than in other Asian markets, retailers aren’t branching into better goods as quickly. Also slowing the market is a 37% import duty on polished diamonds and a 65% value-added tax on finished jewelry. Like in South Korea, the high taxes encourage a lot of back-door dealing, which local dealers imply is the source of most of the undisclosed fracture-filled diamonds sold there. These taxes are likely to decline sharply after China absorbs Hong Kong, say dealers. As taxes fall and consumer buying power rises, look for Chinese consumers to go for better-quality quarter-caraters and up, says Wu. In fact, retailers say medium-qualities up to a half carat are already quite scarce and getting scarcer.

Government’s role

The government will likely remain amenable to increasing diamond consumption because it has already encouraged diamond manufacturers to set up shop in the country. And of course, the government has a share in many of the manufacturing operations, including the largest – the Shanghai branch of the China National Diamond and Gem Import and Export Corp., a De Beers sightholder.

China hasn’t fully embraced private enterprise, but the late Premier Deng Xiao Ping’s “government capitalism” transformed the country into a land of bingeing consumers – especially with jewelry.

The government has always held a monopoly on all gold transactions and, until recently, operated virtually all retail jewelry outlets. Its initial foray into the business involved starting numerous “gold shops” all over the country about seven years ago. They were so successful that within two or three years, China became one of the world’s leading consumers of gold jewelry, says the World Gold Council. In the past several years, thanks in part to De Beers’ advertising, these shops have taken on diamonds, helping to bring on the huge growth in diamond sales. Since then, privately owned retail stores have started in business, but they have a difficult time competing against the government because they’re hit with higher taxes on stones and the government-imposed markup on gold. Zhuang says many stores deal in smuggled merchandise to stay competitive; he worries this may ultimately backfire against everyone. “If too many people are breaking the law and consumers get cheated in the process, the government’s attitude may change,” he says.

The government’s hold on all gold sales within the country caused some privately owned manufacturers to switch to platinum until that was declared a strategic metal and its use was restricted. All platinum dealing was then placed under government control.

Competition

Today, thousands of privately owned jewelry shops in China compete with government stores and dozens of privately owned Hong Kong-affiliated diamond polishing operations are moving into the country.

The Hong Kong trade believes the number of privately owned jewelry manufacturers and retailers in China will grow because they can now set up shop without taking on a local partner. In the past, Chinese partners drained profits from such operations.

The China National Diamond and Gem Import and Export Corp., the largest diamond and jewelry operation in the country, has grown to seven factories, including a finished jewelry operation, and five retail shops in Shanghai. The company is owned 50-50 by the central government and Shanghai municipal governments, says Zhuang. He says the operation specializes in 10 pointers to half caraters of excellent make. “We do not do Indian-type goods because we find poorer qualities no longer sell. In fact, that is the case with well-made piques as well,” he says.

Most of the company’s monthly output of 6,000-10,000 carats is exported, says Zhuang. But business became much tougher as Asian economies went soft in the past few years. And the near universal quest for quality has hurt. “Buyers are very picky now,” he says. “Consumers want only better stones, so some of our production goes begging.”

Zhuang counts on increased business from the domestic market to take some of these tough-to-sell goods.

HONG KONG: INWARDLY SPIRALING DEMAND

Hong Kong’s diamond dealers and jewelry manufacturers say they’re not worried about the territory’s change from British to Chinese sovereignty in July (JCK, February 1997, p.140). But they are concerned the East Asian diamond market is concentrating into an ever-narrowing band of salable goods. Hong Kong is still the diamond clearinghouse for many of the stones going to China, Taiwan, Indonesia and the local market. “But we used to sell 70% to 80% of our stocks right away; now 20% moves quickly and the rest sits in the safe begging for buyers,” says a leading Hong Kong dealer.

That 20% moves unbelievably fast, because everyone wants the same things – G to J colors, VS and clean SI goods from melee to caraters and even larger.

Willie Yiu, president of Brilliant Trading, Hong King, says prices for lower colors – especially in melee – are still dropping because inventories are piling up. “De Beers has been educating many consumers out of cheaper goods to the point where everyone wants the same thing,” he says. “At some point, De Beers will have to start promoting lower qualities because they have a lot of those goods themselves.”

Another dealer believes this is the biggest potential problem facing the worldwide diamond industry and that De Beers’ Central Selling Organisation eventually will have to refigure rough prices to allow for better makes and polishing out piques. “We can’t recut goods profitably to make them more salable because everything’s been figured already down to the last penny,” Yiu says.

Even when demand is there for lower qualities, profits aren’t. In fact, dealers say they’ve cut back on diamond imports because profit margins are so low on all but the hottest sellers. It’s not worth the investment to hold stones. “There’s a market paradox,” says one dealer. “You need lots of volume to turn a profit, but there’s not enough salable goods around to maintain that volume.”

Hong Kong dealers share concerns that Asian buyers are starting to buy directly from other diamond centers, cutting them out of the middle. “A fair amount of Asian trade is bypassing us, but most of the smaller dealers in other Asian countries still prefer to come here so business is still sound,” says Gaston F. D’Aquino, director of Diatrader Ltd. and chairman of the Hong Kong Diamond Importers Association. “In a way, it’s only natural because the world is getting more sophisticated.”

In addition, other Asian countries have emulated Hong Kong’s free-spirited economic policies, adding to the local competition.

Hong Kong’s diamond business was down 8% to 10% by value in 1996, partly because of the general slowdown all over Asia. But the changes in distribution also contribute, say dealers.

Hong Kong dealers are now figuring how to induce dealers from Taiwan, Indonesia, Korea and Malaysia to come back to buy diamonds. “We do offer a lot of advantages,” says D’Aquino. “We have the contacts, we have a better insight into Asian markets and tailor our buying to those needs,” he says, adding that Hong Kong is still much closer than diamond centers in the West.

On the retail side, Tiffany, Cartier and Van Cleef have opened retail outlets in other Asian countries, but many wealthy shoppers still journey to Hong Kong because it’s tax-free.

The pan-Asian slowdown also has affected Hong Kong’s considerable jewelry manufacturing industry. Manufacturers say a shakeout is on the way. Many have lived off 10%-15% yearly growth rates, but it’s unlikely such across-the-board growth will return any time soon. “Many of these manufacturers can remain competitive because Hong Kong’s connection with China offers a low-wage labor base,” says Charles Chan, director of Continental Jewelry, one

of the city’s largest manufacturers. “However, competition is so keen that profits are very low; many will decide it’s no longer worth the effort to stay in the business. In the future, we’ll see newcomers with new ideas coming in so the cycle will continue. Hong Kong’s always been this way,” says Chan. “That’s why we’ll always be a center for the Far East – we’re flexible and always trying to improve.”

JAPANESE RETAILER TAKES ABOUT-FACE; STAKES FUTURE ON VALUE

When Maki Jewellery, Japan’s largest jewelry retailer, wanted to transform its down-market retail image, it went back to an age-old idea: the jeweler as a source of value.

President Kazuo Kimura is accustomed to thinking big. Just how big has astounded the Japanese trade. In March, Maki, with annual sales of $1 billion, began to market an estate jewelry collection that consumers can cash in if they wish to later.

Maki’s target is women who’ve put off acquiring expensive non-bridal jewelry since Japan’s economic bubble burst in 1991. Kimura is betting a multimillion-dollar promotion budget that Maki can induce shell-shocked Japanese consumers to spend money on high-ticket jewelry – particularly since a “jewelry exchange” division will broker a customer’s piece to another buyer if she wishes to sell. “Anyone who buys jewelry from our estate collection can use this service,” says Kimura. The average piece in the collection costs US$2,900.

Along with the brokerage service, Maki set up a credit bureau to lend customers up to 30% of the value of the piece at 7% yearly interest. “We’re offering this service in tandem with a leading financial institution,” says Kimura. “This includes a 10-year guarantee against fire and theft.”

Maki’s research found the biggest competition for fine jewelry sales in Japan is travel abroad. Therefore, Maki also offers a sort of “travel insurance” package that uses a customer’s jewelry as a guarantee.

The system works like this: Customers register their passport number with the serial number of their jewelry purchase. Both are logged into a computer. If they lose their money and passport while traveling, Maki, working through several travel services, will advance them up to US$970 and help to get their passport reissued quickly. “We want to create demand so people will buy jewelry first, then go abroad,” says Kimura. “We believe this service will give us a competitive edge.”

The company hasn’t skimped on promoting the collection either. Maki paid supermodel Cindy Crawford’s million-dollar fee to wear one of its estate pieces in a workout video for the Japanese market. Actor Bruce Willis got a similar fee for promoting the company’s line of men’s diamond jewelry. The line – called “Diamond Twins” – features matching or complementary men’s and women’s pieces. “Men’s jewelry is not that popular in Japan yet, but we believe it could be a US$2.9 billion market eventually,” says Kimura. He believes Maki will have 20% of that total within 5 years.

For Maki, the new programs comprise a risky effort to reignite consumers’ interest in jewelry. But it’s a risk the company feels it should take because Japan’s recession has hit Maki’s parent company, Miki Corp., hard. Sales have fallen 30% and debts have climbed in the past two years.

Maki enjoyed great financial success in taking Japanese consumers downmarket in the early 1990s. Its showcases were filled with hundreds of tiny gold earrings, rings and pendants strewn about like so much confetti.

But lingering recession and an emphasis on owning things of value after the Kobe earthquake in 1991 brought a renewed frugality and a greater desire for quality. This is what set the stage for Maki’s reinvention of itself and a new emphasis on quality.